4. Debt (or leverage) management ratios

Companies have the opportunity to use varying amounts of different sources of financing, including internal and external sources, to acquire their assets, debt (borrowed) funds, and equity funds.

Company A uses long-term debt to finance its assets, and company B uses capital generated from shareholders to finance its assets. Which company would be considered a financially leveraged firm?

Company A

Company B

Which of the following is trueabout the leveraging effect?

Interest on debt is a tax-deductible expense, which means that it can reduce a firms taxable income and tax obligation.

Interest on debt can be deducted from pre-tax income, resulting in a greater taxable income and a smaller available operating income.

Purple Panda Products Inc. has a total asset turnover ratio of 3.50x, net annual sales of $25 million, and operating expenses of $11 million (including depreciation and amortization). On its balance sheet and income statement, respectively, it reported total debt of $1.75 million on which it pays a 7% interest rate.

To analyze a companys financial leverage situation, you need to measure the firms debt management ratios. Based on the preceding information, what are the values for Purple Pandas debt management ratios?

Ratio	Value
Debt ratio
Times-interest-earned ratio

Influenced by a firms ability to make interest payments and pay back its debt, if all else is equal, creditors would prefer to give loans to companies with high times-interest-earned ratios (TIE).